VIETNAM NATIONAL UNIVERSITY HCMC

INTERNATIONAL UNIVERSITY – SCHOOL OF BUSINESS

CORPORATE FINANCE GROUP REPORT

Case 2

Lecturer: Dr.Nguyen Kim Thu

Group member:

1. Bui Thanh Hoa BAFNIU12 042

2. Tang Kim Duc BAFNIU12 085

3. Le Ha Duong BAFNIU12 041

4. Pham Chi Trung BAFNIU13 103

5. Vo Anh Huy BAFNIU13 242

6. Trinh Hoai Minh Hieu BAFNIU13 160

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TABLE OF CONTENTS

I. Case summary ..........................................................................................................................................3

1. Overview about the music industry and EMI Group ..........................................................3

2. Digital revolution and its effects to music industry and EMI ...........................................4

II. Analysis of dividend policy’s effects to EMI .................................................................................6

1. Irrelevance of dividend policy ................................................................................................6

2. Information content of dividends ...........................................................................................6

3. The Clientele Effect ....................................................................................................................7

4. Bird-in-hand theory ...................................................................................................................7

5. Agency cost theory .................................................................................................................8

6. Transaction cost theory ............................................................................................................8

7. Pecking – order theory ..............................................................................................................8

III. Recommendations for EMI case ....................................................................................................9

References ....................................................................................................................................................11

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I. CASE SUMMARY

1. Overview about the music industry and EMI Group

The music industry is defined as “businesses and organizations that record, produce,

publish, distribute and market recorded music” (SIC, The Standard Industrial Classification) and is

combined of four main participants: the artist, the fans or listeners, the music agents and the

distributors. EMI, Sony BMD, Universal, and Warner are the biggest four companies in the music

industry and in 2005, they accounted for 71.7% of the worlds recorded music. The music industry

is said to become oligopolistic market structure because of their power in financial, legal and

technological muscle. However, over the years the nature of the music industry has significantly

changed and during the digital era, all the companies, even these biggest ones are suffering

significant transformation.

The Electrical and Musical Industries (EMI Group Limited), also known as EMI Music or

simply EMI, was a British multinational music recording and publishing company, and electronics

device and systems manufacturing company, headquartered in London. They were formed in 1931

in London by the merger of the Columbia Graphophone Company and the Gramophone Company.

They had made many successes during the 1950s-1960s, accounted for two-thirds of the world

recorded music and publishing sales. In 1956, the singer Elvis Presley signed with EMI became

global event, which his album is released in both UK and US or in 1958, Cliff Richard signed to EMI,

the star of 50 year career with the label and other famous stars and bands such as the Beatles ,

Diana Ross, the Supremes.

The EMI has two major fields: recorded music and music publishing, which are also the key

drivers of revenue of the company. The first major is about finding the potential artist with long-

term cooperation and the other, publishing right owners. Beside the long-term goal, both division

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also target to the acquisition of some commercial potential group (Capitol Record Label in 1955 and

Virgin Music Group in 1992) or the purchase of existing assets (Motow founder). EMI’s recorded

sales came from both old and new songs recordings, which made up of about 30-35% of the

division’s unit sales. The second major, EMI Music Publishing focused on actual songs as opposed to

the recordings, including three major categories of publishing-rights owners: the lyric’s author, the

music’s composer, and the publisher who acquired the right to exploit the song. In addition to

seeking out and signing flourishing recording artists and song writers to long-term agreements,

both EMI divisions also expanded and enhanced their individual catalogs and artist rosters by

strategic transactions. The two key acquisitions for EMI’s recorded-music division were 1955

acquisition of Capitol Records - a leading American record label, and the 1992 acquisition of Virgin

Music Group – then the largest independent record label. Both divisions pursued the goal of having

the top-selling artists and songwriters and the deepest, most-recognized catalog assets.

2. Digital revolution and its effects to music industry and EMI.

Since the combination of digital audio, Internet, and MP3 file format, the music industry was

brought into a new crossroads – the digital revolution. The digital revolution has had a significant

effect on the global music industry. This has created a new opportunity for both producers and

consumers in production, distribution or enjoys and consumes music. In the positive side, the

combination between the Internet and digital devices has opened the new way of listening as well

as consuming the records, which is easier, more comfortable, more convenient and lower costs.

However, on the other side, the producers surely suffer the loss in the transformation

period because consumers change their incentive to buy physical product to virtual one. It means

that instead of buying full of the album recorded in hard disc, people usually download their

favorite track, that seriously lead to the diminishing in CD products in any retailers in the world.

Driving this change is a consequence of series factors. The growth in mp3 downloads and P2P

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(peer-to- peer) software has provided the “interface for uploading and downloading with ease.”

There is a shifting consumption trend from demand for the physical product to online ones. In

America, according to Nielsen SoundScan, the volume of physical albums sold dropped by 19% in

2007 from the year before—faster than anyone had expected. For the first half of 2007, sales of

music on CD and other physical formats fell by 6% in Britain, by 9% in Japan, France and Spain, by

12% in Italy, 14% in Australia and 21% in Canada. (Sales were flat in Germany.) Paid digital

downloads grew rapidly, but did not begin to make up for the loss of revenue from CDs. More

worryingly for the industry, the growth of digital downloads appears to be slowing. Another aspect

driving this change is the growing number of people burning music on to discs and by implication

diminishing the physical purchase of music. At the end, record companies are no longer in a

dominant position of control. Digital technologies are also affecting the industry’s structure causing

a re-shuffle of the value chain. Artists have the ability to sell directly to their fan via the internet

taking a more active role in the industry’s value chain. The implication of this is that some artists

are by- passing the record companies in favor of setting up their own independent companies,

leveraging the internet as a tool for communication, distribution and marketing. Briefly, while

technology has brought many opportunities, it has however simultaneously led to a massive

increase in piracy. The ease of access and consumption of music online has diminished the

perceived value of the industry. With this mass-availability of illegal and un-paid for music, the

industry experienced an overall market decline.

In fact, EMI has declined in the revenue (27%, from GBP 2,282 million in 2001 to GBP 1,660

million in 2006) as well as other ratio such as the earning per share, the stock price of company… In

2007, the recorded-music division revenues were expected to decline 6-10%, and in February

2007, the actual decrease was 15%, and the profits were negative. Its earning per shares (EPS) had

also dropped from 10.9p to (36.3) p in 2007. Digital revenue, instead, had grown by 59%, and

would represent 10% of the total revenue.

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The board of EMI had already declared an interim dividend of 2p per share in November

2006 and were considering about an additional 6p final EMI dividend to be paid. Our next chapter

of the report will analyze the influences of this decision to the EMI group, and then give the

recommendations.

II. ANALYSIS OF DIVIDEND POLICY’S EFFECTS TO EMI

1. Irrelevance of dividend policy:

The timing of dividends doesn’t matter when cash flows don’t change.

In the case of EMI group, whether they choose to pay dividend or not, they can’t affect much to

the investors because they have the right to sell a portion of their portfolio of equities if they want

cash. Whether they use alternative policy or homemade dividends, it stays the same to investors in

long term because it has little to no impact on stock price.

2. Information content of dividends

Stock price generally rises when the firm announces a dividend increase and generally falls

when a dividend reduction is announced.

Cash flow volatility: If firm’s cash flow is volatile, firms maintain a low dividend payout ratio to

avoid having to cut dividend in the future

In the case of EMI group, EMI management planned to make a joint announcement with Apples,

which helped them getting to a better position and the new format would sell at 30% premium.

That restructuring program brings to them many benefits. However, they had to face up with the

surprise removal of the recorded-music division ahead. EMI group was not sure that they would

have a great growth in the future. So if they decided to announce about the growth of firm's future

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earnings in the future, they had to assure that they could do it, or they would face the risk that they

have to cut dividend in the future.

3. The Clientele Effect:

This theory assumes that investors/shareholders are divided into different groups with different

preferences. Because of that, market force will make it most beneficial to the stock price if the

company chooses the dividend policy so that it satisfies demand.

If we assume that the market is clear, which means it has found its optimal distribution of firms’

dividend payment, then deciding not to maintain current payout may hurt stock price. However,

this assumption can be problematic because of the uncertainty around the November 2006

dividend announcement of 2p per share, the industry itself is also in such state that it is very hard

to predict.

If that assumption doesn’t hold, we may want to take a look at EMI’s share concentration. EXHIBIT

6 shows that large shareholders (1,000,001 or over share owned) dominate equity possession

(83.3%). In fact, the biggest shareholders (FMR Corp) own more than 14% of EMI’s capital. Due to

tax advantages, these large institutes may want to have high cash dividend payout. With substantial

shareholders’ interest in mind, the firm would want to keep 8p per share policy as oppose to 2p per

share.

4. Bird-in-hand theory:

Investors may prefer current dividend to a promise of a higher but risky income in the future. The

assumption is reasonable in this context as two of the EMI group’s sub companies (EMI Records,

EMI Publishing) are moving in opposite direction. Therefore, keeping an 8p per share dividend is

preferable. It is also worth noting that this theory seems to only be applied for short-term investors.

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5. Agency cost theory

Dividend payments play a key role in keeping cash away from manager, reducing the agency costs

of the company (Rozeff, 1982; Easterbrook, 1984). There are three important implications of this

theory:

This theory provided that the firm with less growth opportunities and more free cash flow

pay higher dividends to prevent manager from wasteful activities. In the case of EMI group, this is

probably the most useful implication of the agency cost theory. As the revenue of the company is

expected to reduce by 15% due to the downturn of music industry, there is not likely that EMI can

find a potential growth opportunity in short term. Therefore, there is a chance for managements to

employ free cash flow for wasteful activities or inefficient investment. The company should take

into account this implication of Agency cost theory when considering a new dividend policy.

6. Transaction cost theory

According to Fama (1974) and Higgins (1972), Firm with high transaction costs of equity or debt

issuance should pay less dividends, since it will cost them more to raise external financing to meet

investment needs. Based on this theory, firms with high financial leverage tend to have high

transaction costs, hence pay lower dividends. Furthermore, firms that have high prospective

growth tend to conserve funds for reinvestment by establishing a lower payout ratio.

It can be seen from the current financial position of EMI that the company is currently using

a high proportion of debt. In comparison to the competitor Warner, the gearing ratio of EMI is much

higher in the period of 3 years from 2005 to 2007; the gearing ratio of EMI is approximately 2:1 in

2007, compared to 0.5:1 of Warner. Thus, applying the implication of transaction cost theory, EMI

may consider reducing the payout ratio.

7. Pecking – order theory

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This theory mentions the relationship between investment opportunities and payout ratio (Myers

and Majluf, 1984). In details, firms with more investment opportunities pay less dividends, since

those firms prefer internal financing than issuing securities to finance their investment needs.

However, as the music industry is in downturn, there are not many investment opportunities, EMI

investment opportunity may consider to increase the dividend payout.

III. RECOMMENDATIONS FOR EMI CASE

After considering several theories, we recommend EMI to decrease its dividend payout for the

following reasons:

First, the reason for EMI ill-performance is due to the downturn of music industry. That being said,

the signaling effect of keeping a high dividend payout cannot save the company from losing

investors. Investors are well-aware of the fact that the industry becomes unpromising and the

decline in EMI’s revenue, receiving high dividend alone will not make them rethink about

withdrawing their money if they really want to. In this case, a more clever move for EMI would be

to decrease dividend payout and have strategies to sustain the future growth and future cash flow.

They should persuade investors that they have been prepared and can survive even if the core

business turns bad. Then investors will not go away.

Second, the payout of dividend reduce the flexibility of the company to research and go into another

business or to enhance the core division to catch up with the current trend. In other words, giving

out to much cash devastate the company’s ability to survive. On the other hand, giving shareholders

too much at the down time may make them go away faster. For one thing, investors know a

struggling company without money will have little ways to innovate. For another thing, while

investors do not expect to receive much payback, knowing the business cannot afford it. If they

receive too much, they will think that they have already receive enough for their investment. Then

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they will go away as they know it is unlikely to receive any more payback from this company. If EMI

reduce dividend, investors may be more likely to stick to the company as they think they did not get

a good enough return and expect a better future payback.

Third, keeping the dividend high incurs lots of costs. The company may have to issue more debt to

pay dividends, which in turn increase the financial distress costs, darkening the company’s future.

Moreover, during these time it is hard to borrow at a favorable cost, which will make EMI lose more

cash, which may be used to save the business.

In summary, the strategy of keeping a constantly high dividend will fail sooner or later it is the right

time for EMI to reduce dividend and use that money to help its business survive. Strategic investors

are aware of the industry downturn and are expecting EMI to have a suitable strategy for future

growth, not a high dividend.

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REFERENCES

Article “The music industry: From major to minor”, The economist’s website:

http://www.economist.com/node/10498664

Case study 27: EMI Group plc, Case Studies in Finance, 6th ed., 2010, McGraw Hill,

Toronto, ISBN

Eugene F. Fama , "The Empirical Relationships between the Dividend and

Investment Decisions of Firms." American Economic Review, 1974, 64(3), pp. 304-

18.

Frank H. Easterbrook, The American Economic Review, Vol. 74, No. 4. (Sep.,

1984), pp. 650-659

Myers, Stewart C.; Majluf, Nicholas S. (1984). "Corporate financing and

investment decisions when firms have information that investors do not

have". Journal of Financial Economics Vol.13, No.2, 187–221

Rozeff, Michael S., Growth, Beta and Agency Costs as Determinants of Dividend

Payout Ratios. Journal of Financial Research, Vol. 5, No. 3, pp. 249-259, Fall 1982